Banking, finance, and taxes

Junk Bond Spreads Continue to Tighten, Another Yield Bubble Starting to Form

If the spread of junk bonds keeps contracting as investors clamor for yield in an environment where yields are so low, they are going to be priced where investment-grade bonds used to be priced. Standard & Poor’s tracks these spreads daily and weekly, and the composite spread has contracted to 531 basis points. Many shorter-dated junk bonds have spreads that far narrower than that.

S&P also said that the investment-grade composite spread tightened by 2 basis points to 177 basis points, versus the speculative-grade composite spread narrowing by 5 basis points. Here is the breakdown of how the composite spreads are based:

  • BB spread narrowed by 4 BPs to 355
  • B spread narrowed by 5 BPs to 555
  • CCC spread narrowed 8 BPs to 882

There are some things to consider here. Junk bond yields have recently been trading under 6% in many cases, and that is a first. The SPDR Barclays High Yield Bond (NYSEMKT: JNK) exchange traded fund is at $41.15 and that is only five cents less than the 52-week high, as the 52-week price range is $37.51 to $41.20. Yahoo! Finance shows that ETF having a yield of 6.78%, but we would warn that its dividends tend to fluctuate from quarter to quarter, and there was recently an additional payment.

There are two closed-end funds we track as well. BlackRock Corporate High Yield Fund V Inc. (NYSE: HYV) is at $12.92, against a 52-week range of $11.40 to $13.58, with a 8.3% dividend yield. Another fund is the Western Asset High Income Opportunity Fund Inc. (NYSE: HIO), at $6.70 against a 52-week range of $4.72 to $6.82, for a normalized dividend of about 7.5%.

The contraction was also in most of the major sectors, like banks, industrials, utilities, financial institutions and telecom. As far as how these spreads compare, spreads are now very narrow by any historic comparison. S&P said that the investment-grade composite spread is lower than both its one-year moving average of 202 BPs and its five-year moving average of 246 BPs. The speculative-grade composite spread is lower than both its one-year moving average of 638 BPs and its five-year moving average of 759 BPs.

S&P does offer some warnings here. Its report said:

We expect continued volatility in the near term, especially in the speculative-grade segment, which could result from both positive and negative factors. On the positive side, we expect U.S. corporate defaults to remain below the long-term average in the short term. On the negative side, an increase in volatility in the financial markets, influenced by weakening economic conditions, could continue to weigh on risky assets.

If these spreads tighten too much, then junk bonds are going to become a serious sell rather than a cautious sell. All contractions and expansions can go too far, and this yield contraction after the resolution of the fiscal cliff is being aided and abetted by a more stable economic outlook and investor demand for higher income. Just be advised that the smart money has been making this move for well over a year.

Also be advised that many firms are still positive on the sector. We saw that at the end of 2012 BofA/Merrill Lynch projected that junk bonds could return 7% for investors in 2013.

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